Investors in the Middle East Will Find that Reforms, While Slow, Are Coming

The Middle East region can, in several respects, claim a number of advantages over other areas. It has substantial financial assets, a strong resource base, 300 million people who share a common language and tradition, a history of entrepreneurship that goes back thousands of years, and a strategic location between the East and West, according to Wharton finance professor Richard Herring.

“But it also has substantial problems,” added Herring, who was the moderator of a panel session entitled “Regional Capital Markets and Investment Opportunities” at the recent Wharton Global Family Alliance conference in Dubai.

The problems take a number of different forms. “Unemployment is huge, more than twice the global average,” Herring noted. “Meanwhile, the governments are very heavily subsidizing most of the existing employment.” In addition, despite highly underutilized resources in the Middle East, “the region is typically a major investor [outside its borders], sending abroad around 3.9% of GDP.” This activity “is not balanced by foreign flows into the region, because, after all, the Middle East is a very specialized economy ….”

As a result of this situation, the region lags in direct investment inflows, which is unfortunate because such investment tends to bring with it “other useful things — like knowledge transfer, technology, access to markets and so forth,” Herring said. “Why are we not seeing capital markets look at long-term financing for growth and development in this area? One of the preconditions that the World Bank emphasizes [for investing] is corporate governance.” For example, minority shareholders typically are worried about who controls the investments. These concerns can only be laid to rest by maintaining very strong disclosure practices. Those countries that do follow such practices have better access to equity and financing, more entrepreneurial activity, higher stock turnover, higher stock valuations and greater wealth, Herring suggested, citing a study from the World Bank.

“When you disclose details of family ownership and indirect ownership, minority shareholders feel secure,” he noted. “While internal audit committees deal with financial integrity, external audits mean that the numbers can be verified. The disclosure and availability of ownership and financial data are critical to monitoring and maintaining a transparent structure.” He cited as examples the West and even the BRIC group — Brazil, Russia, India and China — which are getting much more direct investment than the Middle East. Jordan, which has strong disclosure rules, is an exception.

The Middle East needs a number of reforms, Herring warned. Without them, “investors will put their money in banks and real estate or transfer it outside the region. This will result in money not reaching the business activities that are needed for growth in this area.”

Big and Small Fish

According to Omar Masri, founder of the Atlas Investment Group in Jordan and a member of the panel, very few investors were looking at this part of the world in 1993. “But in the last 24 months, the region has been completely transformed in terms of trends and potential. We are talking about 22 countries, from Morocco to Oman, 300 million people and 12 markets.” However, he noted, many countries are still closed off to foreign investors. “In terms of total market capital, we are looking at a $650 billion figure, which is very small compared to other emerging markets. The six countries that make up the Gulf Cooperation Council (GCC) — Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and UAE — account for $500 billion of that figure. Of that total, Saudi Arabia accounts for $320 billion. These markets are mostly closed off to non-GCC investors and certain sectors are completely closed off to any investor.”

Masri said that by the end of 2004, market trading volumes stood close to the $600 billion mark. Underlying trends include a spike in oil prices, a low interest rate environment, the aftermath of 9/11, privatization programs and a huge growth in IPOS. “Last year we saw $3 billion worth of IPOS. This year, we will see a three-fold increase. The capital markets are encouraging family businesses to go public. Take the case of the Saudi-based Al Bilad. About 8.5 million people in the country subscribed to the IPO. There is a thirst. Hopefully, supply will meet demand in the near future.”

Omar Alghanim, head of the Alghanim Industries in Kuwait, agreed that there was a change in the capital markets scenario. “Currently, IPOS are over-subscribed and there is a lot of optimism in the market. Growth between 2000 and 2004 showed a CAGR (compounded annual growth rate) of 55%, but a lot of that is driven by oil prices,” said Alghanim. The general situation is that the top five companies represent 50% to 70% of total market capitalization. “The big fish do well and the small don’t do well,” he noted, adding that many companies do not disclose their financials and there is an asymmetrical information flow. “The markets are great and everyone is happy, but we have to be careful and understand that rising oil prices make us ignore other issues that need to be addressed.”

According to John Morris, CEO of Clearbrook Financial USA, an investment management company in the U.S., the last couple of years have seen amazing activity in this region. “There is an increasing participation, an increasing number of businesses being created and opportunities for listing on the markets.” Capital markets provide economic growth, thereby promoting employment, benefiting the middle class and allowing wealth transfer, he said, adding that many conference delegates were present to look for partners in the region. The next chapter will be the turning point in terms of growth. “Overcoming the burden of oil and [meeting] the challenge of going through structural change are necessary.”

Already, he added, changes can be seen in the capital market reforms and regulatory steps undertaken by the Dubai Financial Services Authority Board and Dubai International Financial Exchange as well as the Central Markets Authority in Saudi Arabia. Qatar has partially opened its markets to foreign investors and has similar plans for a financial center. Bahrain is also showing a great desire for change with its own financial center, a $1.3 billion project expected to be fully operational by 2009.

The last panel member, Habib Al Mulla, chairman of the Dubai Financial Services Authority board, suggested that transparency is the catalyst for the existence of a financial center. One of the key reasons why the Middle East has not seen substantial financial services is that it has never had world class regulation. “It lacked a degree of legal and regulatory certainty needed by international financial institutions,” he said. “This is where the Dubai government initiated a bold vision to create the Dubai International Financial Center (DIFC)” with legal and regulatory standards comparable to international ones.

So far, 13 institutions have been authorized to participate and the number could go up to 40 by the end of 2005, according to Al Mulla. At that time, “we will launch the international DIFX, which will use Euronext technology and offer debt instruments, securities and bonds — a first of its kind in this region. The fact that our neighbors, Bahrain and Qatar, have followed suit in establishing and promoting world class financial centers shows” that people recognize the importance of these initiatives.

The panel members also looked at other issues, including the rise of Islamic finance and banking, and the necessity for a single GCC currency, which is slated to come into effect by 2010. “We are seeing the rise of Islamic finance in this area, a sector that is growing at a rate of 15% to 20% per annum,” said Masri. The interesting point is that non-Arab and non-Islamic corporations are showing a great deal of interest in Islamic finance. For example, Germany recently issued a sukuk, or an Islamic bond, which is a bond that is Shariah-compliant (Islamic-law compliant). These bonds pay no direct interest, which Muslims consider usury. Instead, they place the proceeds of borrowing in pooled Sharia-approved investments and make regular payments based on profits.

Regarding the single currency, Al Mulla explained that the GCC, which is structured like the EU, agreed to launch a single currency in 2010, but that recent political friction between Saudi Arabia and Bahrain over the Bahrain-U.S. FTA (Free Trade Agreement) seems to have pushed back the future of the GCC union. However, “if things move back on track, we should see the possibility of the single currency,” he added.

Herring asked if the region would see the rise of competitive financial markets or one dominant market. Morris responded that a regional market is probably even more important than a regional currency. “It would be welcome from a global perspective because a regional exchange would create social value and sustainable growth.” Alghanim said that while the regional market was a good idea, his biggest fear was whether, and how, its regulatory body could ensure transparency in different countries.

Wealth Creation

In the next panel session, entitled “Entrepreneurship and Capital Flows,” Wharton management professor Raffi Amit noted that between 1994 and 2000, wealth creation came from family businesses led by entrepreneurs. Panel member Mohammed Alshaya, CEO of MH Alshaya Co., Kuwait, said that his family of entrepreneurs was trained into a risk-taking culture. The group is active in real estate, automotive dealerships and distribution, retail and trading as well as information technology and advertising. “In 1890, my grandfather and his brothers started a trading business in Kuwait and I am the third generation. Entrepreneurship is very vibrant in this part of the world.” For example, MH Alshaya Co.’s retail division operates over 650 franchise stores across eight countries.

Governments in the region are now extending a helping hand to those interested in starting their own companies. The Kuwait Investment Authority has put up $50 million to help young entrepreneurs start businesses. Saudi Arabia and other Gulf countries are giving more encouragement to small and medium enterprises. UAE has the Mohammed bin Rashid Establishment for Young Business Leaders, while Saudi Arabia established the Centennial Fund to provide support to young Saudi entrepreneurs.

Alshaya agreed that the challenges facing the private business sector in the Gulf — where 95% of the companies are family-run businesses — include how to move forward without breaking up. Indeed, market analysts say families have been reluctant to go public as they want to keep control of their companies and avoid exposing the operations to outsiders, as required by disclosure rules. Besides, the process of going public is long and convoluted, which is discouraging to some owners.

David Jackson is chief investment officer of Istithmar, a major investment holding company in Dubai. Launched in 2003, Istithmar coordinates various entrepreneurial ventures in sectors like real estate, logistics, tourism, retail and financial services for corporations and private investors. Jackson noted that while his company is being approached by families looking for expansion capital, they are still going through a learning curve when it comes to the dos and don’ts of private equity issues. The reasons are simple. “Entrepreneurs start companies and are very attached to them, financially and psychologically,” he said.

Elwy Taymour of Arabfinance, a private equity company that specializes in online financial services in Egypt, spoke of his experiences as an entrepreneur setting up three different companies in Egypt. He noted that governmental assistance was crucial for the survival of entrepreneurial ventures. Laird Pendleton, chairman of the Wharton Global Family Alliance Board and co-founder of the U.S.-based Cairnwood Cooperative Corp., emphasized that each family business has to reinvest in itself and also must establish a culture where failure is allowed.

The session ended with an address by H.E. Mohammad Khalfan Bin Kharbash, UAE Minister of State for Finance and Industry. “There are challenges in succession issues and whether the family businesses will withstand the transitional pressures or not,” he noted. A second challenge is “opening up the family business, which is being forced to restructure and reorganize its operations to remain competitive in the 21st century …. In the global economy, you either grow smaller and smaller or build alliances, and the best way to do that is to bring in new investors. That’s not easy, since one wants to remain in control.”

The same holds true for the UAE. Companies recognize the need to bring professional management into family-owned businesses and facilitate the division of shareholding as family size increases across generations. The splitting of the businesses themselves, in most cases, is not possible, say industry experts.

Creating conducive conditions between the family-controlled businesses and new and interested investors is very important, Kharbash added. “More and more families in the UAE are being encouraged to list partly on the stock markets and go public.”He noted that the UAE government was looking at the rules to ensure that there were fewer restrictions and more positive encouragement for such businesses to publicly list their stock. Market analysts say that one of the pressing economic policy challenges in the UAE is in compliance processes and implementation.

“The law stipulates that families wanting to list on the markets must offer a minimum 55% equity stake to the public, thereby sacrificing majority control of shares, which is not easy,” Kharbash said. The result is that most of Dubai’s family-owned businesses shy away from the capital market, according to analysts who add that current regulations regarding share pricing and minimum equity offerings are harming Dubai’s ability to foster initial public offerings. The regulations force companies to price the initial offering of shares close to their face value, when they should actually fetch a premium.

Reforms are on the way in the form of a new ‘Company Law’ in the UAE. Most of the problems faced by the capital markets and companies will be resolved by this initiative, which will include new laws regarding transparency. There will also be changes in agency law in order to bring practices more in line with globalization and WTO regulations. “In the long run,” said Kharbash, “the ability to maneuver is the name of the game.”

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